A Fresh Start: Selling Free and Clear of Disputed Ownership Claims in Bankruptcy

Issue January/February 2020 February 2020 By Christopher M. Condon
Complex Commercial Litigation Section Review
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Christopher M. Condon

“Fresh start” is a term typically used to describe the benefits an individual debtor receives when discharged of his or her debts in bankruptcy. The discharge settles the debtor’s liabilities and ends pursuit by and disputes with creditors. There is no equivalent corporate discharge, but the bankruptcy process can provide a “fresh start” for a corporation’s assets, which may be sold free and clear of disputed claims and interests to be utilized by a new non-debtor acquirer.

Increasing creditor leverage, resulting both from revisions to the Bankruptcy Code and market forces, has increased the use of asset sales as a means of reorganization in Chapter 11. A bankruptcy sale will typically be approved if the decision of the debtor to sell is supported by “reasonable,” “proper” or “sound” business judgment, a rule commonly referred to as the “business judgment test.” In re Genesys Research Inst. Inc., No. 15-12794-JNF, 2016 Bankr. LEXIS 2376 (Bankr. D. Mass. June 24, 2016) at *62. “A debtor’s business decision to sell should be approved unless it is shown to be so manifestly unreasonable that it could not be based upon sound business judgment, but only on bad faith, or whim or caprice.” In re Cadkey Corp., 317 B.R. 19, 22-23 (D. Mass. 2004).

A Chapter 11 sale is a powerful tool. It provides an expedient and efficient substitute for the traditional bankruptcy plan process, especially where the debtor’s assets are in decline but have value if they can be uncoupled from the failing business. Assets are conveyed quickly upon a motion by the debtor. At closing, the buyer receives the benefit of both a bill of sale and a federal court order, which provide the buyer with protections not available outside of bankruptcy. Principal among those protections is the release of claims and interests associated with the assets, which claims and interests attach to the proceeds of the sale. See, e.g., In re DVI Inc., 306 B.R. 496, 504-05 (Bankr. D. De. 2004) (collecting cases).

The sale power is not without limits. In order to approve a sale, the bankruptcy court must determine that there is good business reason for the sale and that the sale adheres to the substantive protections of Chapter 11. Mission Prod. Holdings Inc. v. Old Cold LLC (In re Old Cold LLC), 879 F.3d 376, 383 (1st Cir. 2018). The debtor must also demonstrate that the “transaction has a proper business justification” and is not designed to circumvent or evade the Chapter 11 sale process. In re GMC, 407 B.R. 463, 491 (Bankr. S.D.N.Y. 2009). Bankruptcy courts have limited jurisdiction and can typically only authorize sales of assets of the bankrupt debtor, or “property of the bankruptcy estate.” See, e.g., DeGiacomo v. Travers (In re Traverse), 753 F.3d 19, 27-28 (1st Cir. 2014).

Creditors or other parties-in-interest may object or attempt to forestall a sale by claiming that the debtor does not own what it is trying to sell. Legitimate disputes as to ownership arise frequently in intellectual property disputes, where, as a for instance, technology may be determined to be dominant or subservient to other patented technology. Litigation of such disputes is inevitably lengthy and costly. Fully adjudicating such a dispute prior to a sale closing would almost certainly erode the benefits of the bankruptcy sale process and either drain or exhaust the resources of an already financially distressed seller.

To avoid these costly and time-consuming disputes that inevitably delay the bankruptcy process, Section 363(f)(4) of the Bankruptcy Code allows a debtor to “sell property under subsection (b) or (c) . . . of this section free and clear of any interest in such property of an entity other than the estate, only if . . . (4) such interest is in bona fide dispute.” 11 U.S.C. § 363(f)(4). While the statute’s only precondition is that such a dispute exists, in the 2004 Rodeo Canyon case, the Ninth Circuit ruled that courts cannot authorize a sale under Section 363(f) until an ownership dispute is resolved. In re Rodeo Canyon Dev. Corp., 362 F.3d 603 (9th Cir. 2004), withdrawn and superseded, 126 Fed. Appx. 353 (9th Cir. Mar. 8, 2005). The opinion is of limited precedential value given that it was later withdrawn by the court when the parties to the matter filed a stipulation stating that certain operative facts upon which the opinion was based were incorrect. Regardless, it has been repeatedly cited for the proposition that “[a] bankruptcy court may not allow the sale of property as ‘property of the estate,’ without first determining whether the debtor in fact owned the property.” Id. at 608-09. Thus, under Rodeo Canyon and its progeny, any third party could hold estate assets hostage by merely questioning whether such assets are property of the estate.

More recently, two Massachusetts bankruptcy courts have considered and rejected the logic of Rodeo Canyon and adopted the majority view regarding the authority under Section 363(f)(4). In re Genesys Rsch. Inst. Inc., Case No. 15-12794-JNF, 2016 WL 3583229 (Bankr. D. Mass. June 24, 2016); In re IDL Dev. Inc., Case No. 18-14808 (Bankr. D. Mass. June 14, 2019). In both Genesys and IDL, the court recognized the very real problem of adjudicating a disputed claim of ownership in estate property prior to conducting a sale, and ruled that the debtor has the burden only to demonstrate that there was a bona fide dispute with respect to the debtor’s interest in the property, not to prevail in the ownership dispute prior to the sale. The Genesys court stated, “[s]ection 363(f)(4) does not contemplate or require that the court resolve or determine any dispute about ownership before a sale hearing, but rather requires only an examination of whether there is an objective basis for either a factual or legal dispute about ownership.” Id. at *20 (emphasis added). Indeed, “‘[t]he purpose of § 363(f)(4) is to permit property of the estate to be sold free and clear of interests that are disputed by the representative of the estate so that liquidation of the estate’s assets need not be delayed while such disputes are being litigated.’” Id. at *19 (internal quotations omitted). This burden to demonstrate a bona fide dispute is significantly lower than the burden to resolve the ownership dispute itself. Section 541(a)(1) of the Bankruptcy Code prescribes property of the bankruptcy estate as encompassing “all legal or equitable interests of the debtor in property as of the commencement of the case.” Bankruptcy courts typically take a broad view in determining whether the debtor has something to sell. The “threshold” determination is satisfied so long as “the disputed property is or could become property of the bankruptcy estate.” In re Robotic Systems Inc., 322 B.R. 502, 508 (Bankr. D. N.H. 2005) (emphasis provided). “‘In fact, every conceivable interest of the debtor, future, nonpossessory, contingent, speculative and derivative is within the reach of Section 541.’” Wood v. Premier Capital Inc., 291 B.R. 219, 224 (1st Cir. B.A.P. 2003) (internal quotations omitted).

As the Genesys court explained, the “evidentiary record required to support a finding of a bona fide dispute for purposes of § 363(f) depends upon a case-by-case consideration of: (i) the procedural posture of the case, (ii) the need to expedite the sale, and (iii) the nature of the basis for determining that a dispute exists.” 2016 WL 3583229 at * 20 (internal quotations omitted). The party asserting an interest in property being sold, not the bankrupt debtor, “has the burden of showing the validity and extent of its interest.” Id. at 21. A bona fide dispute may be established in the context of a contested sale motion and does not require extensive discovery that might otherwise be associated with litigation of the underlying disputed claims of the parties. The disputed assets may then be sold free and clear of such interest, with the interest attaching to the proceeds of the sale, rather than the buyer’s ongoing business.

Bankruptcy sales can be desirable for both the buyer and the seller. The buyer can acquire clean title to a bankruptcy company’s assets supported by a bankruptcy court order determining the purchased assets to be free and clear of disputed claims. Section 363(f)(4) provides a mechanism to sell free and clear of disputed ownership interests, which is a significant tool to quickly and efficiently convey assets to a willing buyer to restart the debtor’s business without the burden of the ownership litigation. 

Christopher M. Condon is a shareholder at Murphy & King. His practice focuses on commercial insolvency, reorganization and related litigation.